A much-criticized new fair-value disclosure provision that can turn an increase in a company’s credit risk into an earnings boost has done just that for Ambac, the beleaguered bond insurer.
As a result of the provision of FAS 157, Ambac was able to parlay the widening credit spreads it suffered as a result of a June ratings downgrade into an earnings gain. On Wednesday, the company reported $823 million in net income, a whopping gain over second quarter 2007 profits of $173 million that stemmed largely from “net mark-to-market gains on credit derivatives.”
That gain, however, was spawned by a big loss in the insurer’s creditworthiness. During the second quarter, Ambac’s credit-derivative portfolio recorded a net mark-to-market gain of $962 million. The fair-value gain “benefited greatly” from an adjustment the company made to account for the widening credit spreads it was experiencing in second quarter, Ambac CFO Sean Leonard explained during the company’s quarterly earnings call.
The credit spreads topped out in June after the rating agencies downgraded Ambac Assurance, the operating company of Ambac Financial Group to the AA level, Leonard recalled. After June 30, however, as the company’s creditworthiness improved, its income statement weakened.”In fact we estimated that if we had used Ambac Assurance’s credit spread as of July 31 instead of June 30, our net mark-to-market would have been a negative $1.3 billion instead of the positive $962 for the quarter,” the CFO added.
Ambac owes the counterintuitive mark-to-market gain to paragraph 15 of FAS 157, Fair Value Measurements. In the paragraph, the Financial Accounting Standards Board states that the fair value of a company’s liability must reflect the risk that the company won’t pay it back. Thus, as the risk that a company won’t redeem its debt rises, its reported liabilities actually decrease.
The provision has drawn heat from critics at two recent Securities and Exchange Commission roundtables on accounting issues and elsewhere. Indeed, at Monday’s session on global accounting standards and the subprime crisis, SEC Chairman Christopher Cox called the provision one of the “anomalies” of fair-value accounting, on that produces “more and more phantom income” and enabling a company is “doing better when the company is doing worse.”
Still, Ambac joined a burgeoning number of companies that are making hay out of the provision, according to a Credit Suisse report on the first-quarter 2008 10-Qs of the 380 members of the S&P 500 that have either a November or December year-end close, the first big companies to adopt FAS 157.
For the 25 companies with the largest liabilities on their balance sheets measured at fair value, widening credit spreads spawned first-quarter earnings gains ranging from $11 million to $3.6 billion, according to the study.